When It Pays to Mix Annuities and IRAs

Most of the time it’s not a good idea to combine an IRA with an annuity. The IRA already has tax deferral, so why take on the costs and limitations of an annuity? But there are a couple of times when it may make sense to mix an annuities with an IRA. We take a look at two such situations.

Managing RMDs

When it is time to take distributions from an IRA, there are two goals of most IRA owners. One goal is to make the income last at least a lifetime, hopefully leaving something for a spouse or younger heirs.

The other goal is compute the required minimum distributions (RMDs) due after age 70½ so penalties are avoided.

The two goals can conflict. RMDs increase the risk of depleting the IRA early. That’s why a goal of many IRA owners is to minimize RMDs.

One way around this conflict is to purchase an immediate annuity about the time RMDs must begin. An immediate annuity begins distributions within a year of purchase and pays the same amount every year for a guaranteed period. Most people purchase an annuity that makes payments for life or for the joint life of the IRA owner and his or her spouse.

The insurer takes care of the RMD compliance, and purchasing an immediate annuity usually is considered to be fulfilling the RMD rules. The IRA owner does not have to worry about computing distributions or consulting the rules.

The annuity comes with the insurer's guarantee that payments will continue for the chosen period. If the insurer has financial difficulties it might not be able to make good on the guarantee. So, it is important to choose an insurer that seems financially secure.

A downside to the annuity is less flexibility. If you have an emergency financial need, your ability to draw additional money from the annuity is limited. With a straight IRA, you can take out as much money as you need above the RMD. Many insurers have loosened distribution rules so that you can take as much as 10% of the annuity balance in a year. The provision increases costs and reduces the annual payouts. It is better to have other assets available outside the IRA to handle unexpected expenses.

Another downside to the annuity is that payments are fixed. They do not increase with inflation, interest rates, or anything else. There are some inflation-indexed annuities available, but they have substantially lower initial payouts. Again, it is good to have assets other than the IRA that can be invested for growth and be available to increase annual spending as costs increase.

The annuity payments can continue to beneficiaries if you select such a payment schedule. That will result in lower payouts during your lifetime, but it ensures something is available to your heirs and the insurer does not profit if you die before life expectancy. The insurer also would manage distributions to beneficiaries. That relieves you of the burden of ensuring they understand how IRA inheritance rules work and can prevent your heirs from spending the entire amount quickly.

Charitable annuity

Taxpayers who are charitably-minded also have a problem with IRAs. The tax advantages of making gifts from the IRA are not great. You can take a distribution from the IRA, include it in gross income, issue a check to the charity, and deduct the contribution. That could result in no taxes, if you itemize deductions on Schedule A and are not in the higher tax brackets for which itemized deductions are reduced.

There is a temporary provision that allows a taxpayer who is at least age 70½ to have up to $100,000 transferred directly from an IRA to a charity. The money is excluded from gross income and no deduction is allowed. But that applies only to a few taxpayers and for a limited time.

One strategy to cope with these problems is the charitable gift annuity. Here is how this strategy works.

The IRA owner takes a distribution from the IRA of any amount, including the entire IRA, which is included in gross income.

The distribution is used to purchase a charitable gift annuity. This is an annuity contract purchased from a public charity. The charity will make regular payments to the owner for life, just as an insurer of a commercial annuity will. The owner can choose from different payment options, such as for life or for the joint life of the owner and a beneficiary.

The amount of the payouts is less than from a commercial annuity. The difference is a gift to the charity, and the owner receives a charitable contribution for the amount of the gift in the year the annuity is purchased.

The amount of the gift is determined from IRS tables that use current interest rates and the owner's age to set the deduction amount. The older the owner is, the greater the deduction. The deduction offsets some of the distribution that was included in gross income. The deduction depends primarily on your age and might offset up to half the distribution.

When payments are received from the annuity, a portion is tax free as a return of your basis or investment in the annuity. The basis is considered to be received pro rata over your life expectancy. Contrast that with when an annuity is purchased directly by the IRA. In that case, all of each distribution is likely to be included in gross income.

The charitable gift annuity strategy should be used only by someone who has charitable intentions. But for such people when the charitable contribution is considered along with the partial tax-free treatment of each payment, the after-tax cash is likely to be comparable to that of simply purchasing an annuity with the IRA.

The promise to make the payments is backed by the charity. If the charity founders financially, it might default on the annuity payments and you would be an unsecured creditor. We have seen a number of smaller charities suffer financially in the bear market or because they invested with con artists such as Bernard Madoff. Take care when determining the charity with which you do business. Favor a long-established charity with a diverse funding base and years of experience with gift annuities. Some charities purchase annuities from commercial insurers to back up their obligations. But you would not have ownership rights in that annuity or be entitled to take title to it if the charity defaults or runs into financial trouble. One popular option is to purchase the annuity from a donor-advised foundation or community foundation. These charities support a number of causes and sometimes give donors input into how their gifts are used.

There is no need to shop around for the best payout. Almost all charities agree to use the same payout formula.

When the annuity owner has other sources of income to pay living expenses, the annuity payments might be used to purchase life insurance. The life insurance can pay estate taxes or increase the inheritance of the heirs. The inheritance would be tax free, so that would leave the heirs with a better after-tax position than if they had inherited the IRA. Combining the charitable gift annuity with life insurance could leave the heirs and charity with more after-tax money than the alternatives.

Annuities are attracting more people because of their security and steady, guaranteed income. Some IRA owners will find that annuities can make retirement easier and be a powerful complement to their IRAs.


Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com. He also is author of the books The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Posted 10-02-2009 10:25 AM by Bob Carlson
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